Inflation is at a 40-year high. Stock prices are sinking. The Federal Reserve has just made borrowing even costlier. And the economy actually shrank in the first three months of this year.
Is the United States at risk of enduring another recession, just two years after emerging from the last one?
On Wednesday, the Fed stepped up its drive to tame inflation by raising its key interest rate by three-quarters of a point — its largest hike in nearly three decades — and signaled more large rate increases to come.
For now, most economists don’t foresee a downturn in the near future. Despite the inflation squeeze, consumers — the primary driver of the economy — are still spending at a healthy pace. Businesses are investing in equipment and software, reflecting a positive outlook. And the job market is still booming, with hiring strong, layoffs low and many employers eager for more workers.
“Nothing in the U.S. data is currently suggesting a recession is imminent,” Rubeela Farooqi, chief U.S. economist at High Frequency Economics, wrote this week. “Job growth remains strong, and households are still spending.
That said, Farooqi cautioned, “the economy faces headwinds.”
Among the signs that recession risks are rising: High inflation has proved far more entrenched and persistent than many economists — and the Fed — had expected: Consumer prices rose 8.6% last month from a year earlier, the biggest annual 12-month jump since 1981. Russia’s invasion of Ukraine has exacerbated global food and energy prices. Extreme lockdowns in China over COVID-19 worsened supply shortages.
Fed Chair Jerome Powell has vowed to do whatever it might take to curb inflation, including raising interest rates so high as to weaken the economy. If that happens, the Fed could potentially trigger a recession, perhaps in the second half of next year, economists say.
Analysts say the U.S. economy, which has thrived for years on the fuel of ultra-low borrowing costs, might not be able to withstand the impact of much higher rates.
The nation’s unemployment rate is at a near-half-century low of 3.6%, and employers are posting a near record number of open jobs. Yet even an economy with a healthy labor market can eventually suffer a recession if borrowing becomes costlier and consumers and businesses put a brake on spending.
HOW WOULD THE FED’S RATE HIKES WEAKEN THE ECONOMY?
Higher loan rates are sure to slow spending in areas that require consumers to borrow, with housing the most visible example. The average rate on 30-year fixed mortgages topped 5% in April for the first time in a decade and has stayed there since. A year ago, the average was below 3%.
Home sales have fallen in response. And so have mortgage applications, a sign that sales will keep slowing. A similar trend could occur in other markets, for cars, appliances and furniture, for example.
HOW IS SPENDING AFFECTED?
Borrowing costs for businesses are rising, as reflected in increased yields on corporate bonds. At some point, those higher rates could weaken business investment. If companies pull back on buying new equipment or expanding capacity, they will also start to slow hiring. Rising caution among companies and consumers about spending freely could further slow hiring or even lead to layoffs. If the economy were to lose jobs and the public were to grow more fearful, consumers would pull back further on spending.